The abundance of game-changing new accounting standards issued by FASB has given audit committees a lot to consider as 2018 concludes.
New standards for revenue recognition, lease accounting, and accounting for credit losses have demanded intense focus from company finance departments. Audit committees are charged with oversight and making sure proper governance is in place to enable implementation to be completed successfully.
EY’s annual review of developments affecting audit committees encourages them to maintain their focus on financial reporting and create an environment that supports the integrity of the financial reporting process.
The following tips may help audit committees perform their oversight duties with respect to implementation of key accounting standards.
Public companies are implementing the revenue recognition standard this year, and EY’s Paul Beswick said it’s important for audit committees to stay engaged with management and auditors on implementation.
Beswick, a partner in Assurance Services for EY and a former SEC chief accountant, said in an email that audit committees should:
- Make sure management continues to provide a good tone at the top that creates an environment that supports high-quality financial reporting.
- Continue to challenge the effectiveness of management’s communications with investors and other stakeholders.
- Evaluate any control deficiencies identified by management or the auditor and whether they rise to the level of a significant deficiency or material weakness.
- Encourage management to continually improve the company’s process and controls over revenue beyond the year of adoption.
In comment letters, the SEC has focused on key areas of judgment, Jennifer Lee, senior manager of EY’s Center for Board Matters, said in an email. These include identifying performance obligations, determining the timing of satisfaction of performance obligations, and determining the categories to present as disaggregated revenue.
Private companies, meanwhile, are due to implement the revenue recognition standard beginning in 2019 but are not required to apply the standard in interim periods in the year of adoption.
“The good news for management and the audit committee is that there is a lot to learn from the experience of public companies,” Beswick said. “Having a robust implementation plan and devoting enough resources to the implementation process is critical to a successful implementation.”
Lee said audit committees should make sure they understand the new judgments management is making. She said audit committees should consider:
- Why revenue information is not further disaggregated beyond the segment disclosures, if that is the case.
- Whether information included in the footnote is consistent with information provided to investors in other formats, such as investor calls.
- Whether the company bundles goods and services together in contracts with customers and, if so, whether any of those goods or services have been accounted for as a single performance obligation or unit of account.
- To explain, if single performance obligations exist, the judgments made in reaching this determination, with a focus on evaluating whether the goods or services are significantly integrated or highly interrelated with one another.
“Audit committees should also continue to evaluate the adequacy of the company’s other disclosures required by the new revenue standard,” Lee said. “We believe this evaluation should include the consideration of disclosures by peer companies, industry practice, and other best practices as they evolve over time.”
FASB’s new lease accounting standard takes effect for public companies in 2019, and many companies have found that they need new systems to perform the accounting. In a recent PwC survey, 58% of public companies said they are implementing new systems for lease accounting, and 17% said they are modifying or upgrading existing systems.
Beswick said companies need to test their new or upgraded systems to make sure they are fully functional. If testing can’t be successfully completed prior to adoption, Beswick said management will need to develop controls around any manual workarounds to the systems, for example, by using Excel.
“If management uses Excel to calculate the transition adjustments, it needs to consider the risks related to information produced by the entity and needs to make sure it has effective controls related to the entry of data into the spreadsheet, the setup of the spreadsheet to comply with [FASB ASC Topic 842, Lease Accounting], and the modifications to formulas or data in the spreadsheet,” Beswick said.
A company that uses lease accounting software provided by and hosted by a third party as part of implementation should consider the risks that arise from the processes performed by the service provider, Beswick said.
According to Beswick, audit committees should be monitoring the status of management’s implementation of the lease accounting standard with regard to:
- Completeness of the lease contract population. Locating and gathering all the leases that exist throughout an organization has been a problem for some companies. “Because most leases will be recognized on a lessee’s balance sheet under the new standard, lessees will likely need to implement more robust processes and controls to make sure they identify and account for all of their leases,” Beswick said. “For example, entities may need to implement new controls to identify arrangements that contain embedded leases such as power purchase arrangements and multiple-element service arrangements.”
- Completeness and accuracy of the data used to calculate the transition adjustments. Management needs to assess whether it has effective controls to address the risks of using incomplete or inaccurate lease data, Beswick said.
- The calculation of the transition adjustments. Beswick said organizations need controls over the calculation of the transition adjustments, including the reconciliation of the total right-of-use asset and lease liability to those reported in the financial statements. “For lessees, the discount rate is often a key assumption used to measure the lease liability and may involve significant judgment,” Beswick said. “Management will need controls to address the risks of material misstatement over the estimate of incremental borrowing rating.”
- Prospective accounting policies. Companies can’t wait until 2019 to determine their prospective accounting policies and processes, Beswick said. “During implementation, entities need to develop new policies, processes, and controls to comply with ASC [Topic] 842 after adoption,” Beswick said. “These policies will be different from those identified during implementation.”
Accounting for credit losses
Although banks, financial institutions, credit unions, and insurance companies will be affected most by this standard, companies with large available-for-sale investment portfolios or long-term finance receivables will need to pay close attention to FASB’s new standard for accounting for credit losses, Lee said. She said all other entities are likely to have to change their processes and controls over the estimate of bad debt expense on accounts receivable.
Audit committees of companies with large loan portfolios and long-term finance receivables already should be discussing implementation plans with management, Lee said.
“The audit committee should gain an understanding of the implementation plan and its status and assess whether management has adequate resources and time to address the complexities associated with developing a forecast of future economic conditions and translating that forecast into an estimate of expected losses over the life of the instrument,” Lee said. “Also, management should engage with their auditors early in the process.”
She said that in most cases, companies will need to enhance their control environment to have adequate internal control over financial reporting. The audit committee should understand how the company plans to communicate the adoption of the new model to its stakeholders, Lee said.
“In addition to understanding views of the SEC staff, regulatory agencies, and auditors, audit committees should also make sure they understand how management is tracking changes that the FASB is making to the standard,” Lee said. “We expect the FASB to continue making changes through the early part of 2019, and these amendments will affect the decisions a company makes about the methodology and key assumptions used in developing the estimate.”
— Ken Tysiac (Kenneth.Tysiac@aicpa-cima.com) is the JofA’s editorial director.